CHAPTER 7: THE LABOUR MARKET The non institutional

CHAPTER 7: THE LABOUR MARKET

The non institutional civilian population are the number of people potentially available for civilian employment. The civilian labour force is the sum of those either working or looking for work. Those who are neither working nor looking for work are out of the labour force. The participation rate is the ratio of the labour force to the non-institutional civilian population. The unemployment rate is the ratio of the unemployed to the labour force. 7-1 A Tour of the Labour Market

Figure 7.2 The participation rate of men and women in Europe, 2008 Source: Eurostat 7-1 A Tour of the Labour Market (Continued)

7-1 A Tour of the Labour Market (Continued) Figure 7.4 The average unemployment rate in European countries, 2008(a) The average unemployment rate in Europe hides big differences among countries Source: Eurostat

7-1 A Tour of the Labour Market (Continued) Figure 7.1 Population, labour force, employment and unemployment in the EU27 (in millions), 2008 Source: Eurostat

The Large Flows of Workers An unemployment rate may reflect two very different realities. It may reflect an active labour market, with many separations and many hires, or it may reflect a sclerotic labour market, with few separations, few hires and a stagnant unemployment pool. The European Labour Force Survey (EU LFS) produces employment data, including the movements of workers. 7-1 A Tour of the Labour Market (Continued)

The Large Flows of Workers Figure 7.6 Average flows between employment, unemployment and non-participation in a hypothetical country 7-1 A Tour of the Labour Market (Continued)

From the EU LFS data we conclude that: The flows of workers in and out of employment are large. Separations consist of: Quits, or workers leaving their jobs for a better alternative, and layoffs, which come from changes in employment levels across firms. The flows in and out of unemployment are large in relation to the number of unemployed. The average duration of unemployment is about three months. There are large flows in and out of the labour force, much of them directly to and from employment. Discouraged workers are classified as “out of the labour force” but they may take a job if they find it. The non-employment rate is the ration of population minus employment to population. The Large Flows of Workers 7-1 A Tour of the Labour Market (Continued)

The European Union Labour Force Survey The European Union Labour Force Survey (EU LFS) is a quarterly sample survey covering the population in private households in the EU. In providing data on employment, unemployment and inactivity, the EU LFS is an important source of information about the situation and trends in the labour market in the EU. The quarterly EU LFS also forms the basis for Eurostat’s calculation of monthly unemployment figures. For more on the LFS: (http://circa.europa.eu/irc/dsis/employment/info/data/eu_lfs/ index.htm).

7-2 Wage Determination Collective bargaining is bargaining between firms and unions. Common forces at work in the determination of wages include: Workers are typically paid a wage that exceeds their reservation wage, the wage that would make them indifferent between working or being unemployed. Wages typically depend on labour market conditions. The lower the unemployment rate, the higher the wages.

How much bargaining power a worker has depends on two factors. How costly it would be for the firm to replace him—the nature of the job. How hard it would be for him to find another job—labour market conditions. Bargaining 7-2 Wage Determination (Continued)

Economists call the theories that link the productivity or the efficiency of workers to the wage they are paid efficiency wage theories. Efficiency Wages These theories also suggest that wages depend on both the nature of the job and on labour-market conditions: Firms that see employee morale and commitment as essential to the quality of their work, will pay more than firms in sectors where workers’ activities are more routine. Labour market conditions will affect the wage. 7-2 Wage Determination (Continued)

Henry Ford and Efficiency Wages In 1914, Henry Ford decided his company would pay every qualified employee a minimum of $5 per day for an eight-hour day. While the effects support efficiency wage theories, Ford probably had other objectives as well for raising his wages.

Wages, Prices and Unemployment The aggregate nominal wage, W, depends on three factors: The expected price level, Pe The unemployment rate, u A catchall variable, z, that stands for all other variables that may affect the outcome of wage setting. 7-2 Wage Determination (Continued)

Both workers and firms care about real wages (W/P), not nominal wages (W). Workers do not care about how many dollars they receive but about how many goods they can buy with those dollars. They care about W/P. Firms do not care about the nominal wages they pay but about the nominal wages, W, they pay relative to the price of the goods they sell, P. They also care about W/P. The Expected Price Level Wages, Prices and Unemployment 7-2 Wage Determination (Continued)

Also affecting the aggregate wage is the unemployment rate, u. If we think of wages as being determined by bargaining, then higher unemployment weakens workers’ bargaining power, forcing them to accept lower wages. Higher unemployment allows firms to pay lower wages and still keep workers willing to work. The Unemployment Rate Wages, Prices and Unemployment 7-2 Wage Determination (Continued)

The third variable, z, is a catchall variable that stands for all the factors that affect wages, given the expected price level and the unemployment rate. Unemployment insurance is the payment of unemployment benefits to workers who lose their jobs. The Other Factors Wages, Prices and Unemployment 7-2 Wage Determination (Continued)

7-2 Wage Determination (Continued) Figure 7.8 Duration of unemployment insurance in Europe, 2008 (in months) Source: CESifo DICE database, based on data from EU Commission and MISSOC 2009

7-2 Wage Determination (Continued) Figure 7.9 Employment protection across European countries, 1995 Source: CESifo DICE database, based on data from EU Commission and MISSOC 2009

7-3 Price Determination Y = output N = employment A = labour productivity, or output per worker Further, assuming that one worker produces one unit of output—so that A = 1, then, the production function becomes: The production function is the relation between the inputs used in production and the quantity of output produced. Assuming that firms produce goods using only labour, the production function can be written as:

7-3 Price Determination (Continued) Firms set their price according to: The term u is the markup of the price over the cost of production. If all markets were perfectly competitive,  = 0, and P = W. We can think of the mark-up as depending on the degree of competition in the product market.

7-3 Price Determination (Continued) Figure 7.11 Relationship between trends in product market regulation and wages in Europe (1998, 2003, 2008) Source: OECD, Eurostat

7-4 The Natural Rate of Unemployment In this section we will look at the implications of wage and price determination for unemployment. Let’s assume that nominal wages depend on the actual price level, P, rather than on the expected price level, . Wage setting and price setting determine the equilibrium rate of unemployment.

Since Pe equals P, then: We can divide both sides by the price level: This relation between the real wage and the rate of unemployment—wage-setting relation. The Wage-Setting Relation 7-4 The Natural Rate of Unemployment (Continued)

The natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting. The Wage-Setting Relation Figure 7.12 Wages, prices and the natural rate of unemployment 7-4 The Natural Rate of Unemployment (Continued)

The price-determination equation is: If we divide both sides by W, we get: To state this equation in terms of the wage rate, we invert both sides: The price-setting relation The Price-Setting Relation 7-4 The Natural Rate of Unemployment (Continued)

The price-setting relation in equation (7.6) is drawn as the horizontal line PS (for price setting) in Figure 7.6. The real wage implied by price setting is 1/(1 = µ); it does not depend on the unemployment rate. The Price-Setting Relation 7-4 The Natural Rate of Unemployment (Continued)

Eliminating W/P from the wage-setting and the price-setting relations, we can obtain the equilibrium unemployment rate, or natural rate of unemployment, un: The equilibrium unemployment rate (un) is called the natural rate of unemployment. Equilibrium Real Wages and Unemployment 7-4 The Natural Rate of Unemployment (Continued)

The positions of the wage-setting and price-setting curves, and thus the equilibrium unemployment rate, depend on both z and μ. At a given unemployment rate, higher unemployment benefits lead to a higher real wage. A higher unemployment rate is needed to bring the real wage back to what firms are willing to pay. By letting firms increase their prices given the wage, less stringent enforcement of antitrust legislation leads to a decrease in the real wage. Equilibrium real wages and unemployment 7-4 The Natural Rate of Unemployment (Continued)

Equilibrium Real Wages and Unemployment Figure 7.13 Unemployment benefits and the natural rate of unemployment 7-4 The Natural Rate of Unemployment (Continued)

Equilibrium Real Wages and Unemployment 7-4 The Natural Rate of Unemployment (Continued) Figure 7.14 Mark-ups and the natural rate of unemployment An increase in mark-ups decreases the real wage and leads to an increase in the natural rate of unemployment.

Because the equilibrium rate of unemployment reflects the structure of the economy, a better name for the natural rate of unemployment is the structural rate of unemployment. Equilibrium Real Wages and Unemployment 7-4 The Natural Rate of Unemployment (Continued)

Associated with the natural rate of unemployment is a natural level of employment. Employment in terms of the labour force and the unemployment rate equals: The natural level of employment, Nn, is given by: 7-4 The Natural Rate of Unemployment (Continued) From Unemployment to Employment

Associated with the natural level of employment is the natural level of output, and since (Y=N): The natural level of output satisfies the following: From Employment to Output 7-4 The Natural Rate of Unemployment (Continued)

Key Terms Population in working age Labour force; out of the labour force Participation rate Unemployment rate Separations Hires Labour force survey (LFS) Leavers Layoffs Discouraged worker Non-employment rate Collective bargaining Reservation wage Bargaining power Efficiency wage theories Unemployment insurance Employment protection Minimum wage Production function Labour productivity Mark-up Wage-setting relation Price-setting relation Natural rate of unemployment Structural rate of unemployment Natural level of employment Natural level of output